A & B – Capital Structure
Two companies A Co., and B Co., are in the same business with same level of risk.
A is an all-equity company with annual net cash eanings of $800 thousands at which level they are expected to remain unchanged for the foreseeable future. The company has issued 6.25 million shares of par value $0.05. Its current market capitalization is $5 million.
B s net earnings before interest is $500 thousands and expected not to change in the near future. The company has issued 5 million shares of par value $0.25 and $1 million 5% irredeemable debentures. The market capitalization of the equity is $2.5 million and the market value of the debentures is 80%. Assume both companies distribute all the earnings as dividend and interest.
Ignore tax and transaction cost.
Estimate the cost of capital of A Co., and B Co.
Suppose Peter, a shareholder of B Co. holding $3,000 worth of the shares of B Co., believes the market value of B is overpriced, what would he do to improve his financial position?
If quite a number of shareholders of B Co. did what Peter did, what would happen to the market value of share B What is the equilibrium value of share B?
What are the assumptions made in the above estimation?